What’s changed over the past year in constructing the right portfolio for our clients? Absolutely nothing.
Sure, one could define the fact that stocks have surged and bonds have stayed basically flat as change, but that’s backwards looking.
Since nobody knows how markets (neither stocks nor bonds) will perform going forward, proper portfolio construction should be done to manage risk, not based on forecasting future returns. Here are the keys to portfolio construction, this year and next.
First, control risk. Have the right amount of risky assets (stocks) and low risk assets (high quality bonds) for the client. This is determined by the client’s willingness and need to take risk. If the client has met their goals, they likely should have a conservative portfolio. It’s great to have asset classes with low correlations (alternatives), but remember they must also have positive expected returns.
Second, control costs. Yes, costs and returns are inversely correlated each and every year. Owning the lowest cost and broadest index funds both reduces volatility and increases expected returns.
Third, control taxes. Once an asset allocation has been selected, we must then select both the products and the asset location. Again, the broadest stock index funds are the most tax-efficient as active funds pass through short- and long-term capital gains to our clients. This is even more important with the new 3.8% passive income tax on income over $250,000.
Next, asset location is key. Tax-efficient stock index funds are best located in taxable accounts and tax-inefficient assets such as bonds, CDs and REITs, are best located in tax-deferred accounts such as IRAs and 401Ks.
Fourth, control emotions. If the client panicked and sold when the real estate bubble popped, they could easily do it again. The client must be willing to stick to the asset allocation, meaning they need to be okay with selling stocks to rebalance after a great 2013, as well as buying fixed income, in spite of all the bond bubble predictions.
Though simple, these rules are anything but easy.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes for CBS MoneyWatch.com and has taught investing at three universities.